We write a short, daily note to flag big inflections in volatility data and derivatives pricing as it’s an important source of market intelligence and a key to our process. Email us back if you’d like to be included on the distribution.
Recently, we’ve made a push to externally communicate our process for identifying asymmetric risks from derivatives data and pricing. Below we delve into this process using the recent move in energy-related financial assets, while discussing implied volatility specifically.
In hindsight, we want to highlight some important factors that flagged asymmetric downside risk in crude and its related energy exposures.
Any metric to track the realized and implied volatility relationship requires a lot of context around what else is going on. In other words we don’t consider any factor in isolation. Rather we test the factor’s relevance, and then it’s considered alongside various other factors.
Keith outlined his views on crude oil specifically as it relates to implied volatility’s trend in Monday’s early look:
[After noting high equity market premiums] “Not to be confused with something you don’t hear consensus macro hedge funds whining about: Oil prices, where the market not only has a massive net LONG position but an Implied Volatility DISCOUNT of -7% vs. 30-day realized volatility…
When you see articles calling for corrections in what consensus isn’t long, that’s why implied volatility is trading at a massive premium – everyone who’s missing the up-move is positioning for a correction that hasn’t occurred!”
The implied volatility premium provides important context on investor expectations about the future. The 1st chart below is critical for contextualizing the 2nd and 3rd charts.
Overall levels of volatility should be considered when contextualizing premiums, and the bottom line is that realized volatility, until recently, has trended toward 2014 cycle lows in the liquid crude oil ETF (USO).
So as realized volatility trended lower over the last 3-months with USO remaining range bound, investors became increasingly confident that trend in tightening volatility would continue (as evidenced in the implied volatility discount shown below and mentioned by Keith in the early look). For us this was a signal of caution over action (steer clear in other words).
The trending discounts were a good read-through to complement the bullishness existing in CFTC non-commercial net futures and options positioning, which until this week, made multiple all-time highs the first two months of the year.
The set-up in energy is not a “we nailed it” call-out but rather in important process communication point for how we use one volatility factor (mixed in with other factors) to identify asymmetric set-ups to benefit from, or steer clear of.
We hope this is a helpful quick-hit to explain our thought process as volatility factor commentary gets sprinkled into various forms of communication. We’re happy to have a more in-depth debate with anyone individually. Email us back with any questions.
Ben Ryan
dty
